“Trump-O-Nomics” – An
exploration of the proposals

As readers know, I have been doing a multipart series on the
proposed tax reforms for the last three weeks in Thoughts from the Frontline. My intention is to
finish this week. In part two I talked about what I like about the Better Way
proposal, and in part three I pretty much eviscerated the border adjustment
tax (BAT), which I think has the real potential to create a global recession.
You’ll need to read the series to see why, but a lot of it has to do with
simple game theory, which the measure’s Republican proponents are ignoring. If
you upset the equilibrium, the other partners at the table will change their
strategies, too.

Let me repeat that what I find encouraging about the proposed tax
reforms is that they are fairly radical in the sense that there is not an
obvious constituency for much of what is proposed, and it will require some
real leadership in Congress to get them passed. In the past I have proposed a
series of tax reforms (sometimes with my friend and fellow economist Steve
Moore, in op-eds around the country) that are pro-business/entrepreneur, but we
have always constrained our proposals by what we saw as political reality.

If the Republican leadership thinks they can get the BAT through
Congress, then I’m going to take the constraints off my thinking and propose
something that is even more radical but much more workable and would not come
with the negatives that the current Republican proposal does. (It is also
something that most economists would agree with, at least in theory.) It would
unloose a massive amount of entrepreneurial spirit and free up capital to go
where it can be most productive, AND it will balance the budget. My proposal
will makes the United States heads up more competitive vis-à-vis the rest of
the world world and yet allow other countries to respond in a similar fashion,
making their own economies more competitive but without their having to try to
outcompete with us and thereby hurt global trade. But that’s all for this
weekend…

Today I want to offer as your Outside
the Box an analysis of the current tax proposal from my friend
Constance Hunter, who is the chief economist at KPMG and wicked brilliant. We
spent some time in the Caymans last week talking about these issues, and she
graciously allowed me to send this internal KPMG document to you.

She analyzes the entire proposal and tries to be fair but comes up
with many of the same negatives that I do and a few more besides. One of the
things that Constance and a few readers have noted is that the real, forceful
change that is required to get this reform through Congress will mean that,
without Democratic support in the Senate, there will be an automatic sunset
provision in 10 years that would be devastating to the economy. There needs to
be a real effort to figure out how to create something bipartisan.

Further, in a conversation yesterday at lunch with a large family
farmer, he casually noted how farmers have to borrow money in the spring and
pay it back in the fall. This has been going on for hundreds of years and is
actually a quite well-documented phenomenon of banking cash flows. In the
1800s, New York bankers would game this dollar flow, but that’s a story for
another day.

By not allowing any interest-rate deduction, as the tax-reform
proposal seeks to do, you will simply destroy the family-farming community
nationwide. I think when farm-state Republican Senators realize what this
proposal will do, they will line up to oppose it. Which is good, because I
would really prefer not to see us plunged into a global recession.

One thing that Constance does well is to bring in other economists
and their papers and really get into how the economics community is thinking
about some of the major consequences of this tax plan. Again, it is not that
the current proposal doesn’t have many good features; it is that the bad ones –
which actually allow you to pay for the good tax cuts – go about it in the
wrong way and create serious problems.

Why is this so important? Because if we don’t come up with a tax
proposal that can get through Congress this year, then we’re looking at 2018;
and do you really think the stock market is going to levitate, waiting until
2018 for a tax proposal that’s not even on the table yet? Congress needs to
focus clearly and figure out what they’re going to do – and not do things that
would make the US and global economic situation even worse.

As investors and portfolio managers, we need to be paying
attention to what Congress is saying and doing and figure out how their actions
are going to affect the economy and our portfolios. The right policies and
programs could be very good for the markets. The wrong ones? You’d want to get
out of the way of that train.

As much as I enjoy traveling and the Caymans in particular, it is
good to be back in Dallas for a few weeks and trying to catch up. As I’ve been
hinting, we are getting close to announcing our new approach to portfolio
design and management. It will be available to everyone, but we are especially
looking to make it available to brokers and advisers to use with their own
clients. The team we have put together is actually quite large, and there are a
lot of moving parts to handle to make sure we’re ready for what I hope will be
a strong response when we launch. But getting all the materials and contracts
and agreements and compliance done in advance has been a bigger project than I
realized.

But then, that has been the story of my life. My friends and
partners can tell you that I start projects not realizing how huge they are
going to be until I’m in the middle of them. Kind of like my book on how the
next 20 years will look. What I thought was going to be a fairly
straightforward book is now massively complex, and part of the challenge is to
make sure it’s not a five-volume set but is actually a fairly thrifty overview
of the Age of Transformation.

And with that I will hit the send button and try to get back to my
inbox, plus take care of a lot of writing and research that I need to do. You
have a great week, and remember that no matter what the politicians do to us,
we’ll all figure out how to Muddle Through together.

Your appreciating the reality of complexity analyst,

John Mauldin, Editor
Outside the Box

“Trump-O-Nomics” – An
exploration of the proposals

By Constance Hunter and Jennifer DorfmanKPMG US Economic Update

As Donald J. Trump begins the presidency with promises of greater
GDP growth and job creation, this report examines both the cyclical and
structural backdrop that could impact the efficacy of his plans. The report
will also discuss the border adjustable tax proposal and some possible
implications. The analysis takes into account the more than 20 percent of U.S.
imports that are priced in dollars, a unique situation that alters the normal
currency adjustment assumptions economists make when assessing the impact of
such a tax.

It is debatable how much influence presidents can have over
near-term, cyclical, economic growth. Certainly expansionary or contractionary
fiscal policy has some influence, but in the United States, discretionary
government spending is a relatively small percent of GDP so this influence is
minimal. Presidents have more influence over structural aspects of GDP via
changes to regulation, changes to the tax code, and changes to total government
spending and resulting debt levels.

In terms of the cyclical prospects for the UnitedStates, the
recovery appears to be in about the 7th inning. The Federal Reserve Bank (the
Fed) is hoping its policies can create some overtime innings and a soft
landing; however, this is often the hope of central banks, yet few are lucky
enough to achieve such feats. The
largest constraint to the Fed’s goals is apparent tightness in the U.S. labor
market. For example, the National Federation for Independent
Business1 reports that the number of respondents who say there
are few or no qualified applicants for job openings exceeds the long-term
average of 42 percent. This suggests that even if the participation rate rose,
the lack of labor market depth would still pose constraints for business
expansion despite any new incentives from tax changes or other stimulative measures.

In addition to relatively tight labor supply, the Fed has just
raised rates for the second time in the current cycle. Since the election,
long-term interest rates have risen more than short-term ones due to
anticipation of more frequent rate increases in 2017 and some possible increase
in risk premia due to fiscal policy uncertainty. However, we believe the
biggest contributor to higher rates is the stronger U.S. economy that was in
train before the presidential election. In addition to cyclical momentum seen
in jobs and consumption growth, higher oil prices are supporting a return of
oil and gas investment. Our base forecast for growth in 2017 is now higher than
before the election due to strong growth momentum.

Therefore,Trump enters his presidency at the end of a long, if
tepid, expansion with little capacity for faster growth in the near term.

Nevertheless, during
the first 100 days, the Trump administration will want to achieve some quick
wins. One way to start this would be to streamline regulation.
A study from the conservative think tank, Heritage Foundation2 found
the cost of new regulations implemented since 2008 amount to an average of $15
billion a year spent on compliance. The argument suggests this is money not
spent on generating economic activity and it reduces productivity. Even if this
number is off by 50 percent, given that U.S. corporate investment has averaged
$130 billion a year since 2010, even
$7 billion of extra investment could add up to 50 basis points a year to
investment’s contribution to GDP.

In terms of fiscal stimulus from Trump’s tax policies,
it is important to remember that in addition to lower personal and corporate
taxes, there are proposals
that would create offsets to pay for the cuts. At the moment,
Republicans are united in saying that the tax cuts and offsets are part of the
same proposal and cannot be separated. Therefore,
their economic impact must be assessed in concert.

There is a good reason for the insistence by many Republicans that
spending not simply stay the same while tax revenue declines due to tax cuts,
as this would increase our already high 102 percent general government debt to
GDP levels. Here one can turn to a well-established phenomenon in economics,
the Ricardian Equivalence Theorem.3 Ricardian Equivalence
states that the economic outcome between debt financing and increased private
spending is equal.

Or put another way, there is no free lunch. If tax cuts cause the
federal debt to rise, then companies and households spend and invest less than
the amount of the cut. The
greater the debt level at the initiation of the tax cut the smaller the portion
that is spent or invested.

The first offset is a change
to the deductibility of interest. Under the current House Republican proposal,4interest would no longer be deductible
unless it could be claimed against interest income.

While this is neutral for banks, in isolation it could hurt
heavily indebted industries, many private equity structures, and companies that
rely on debt versus equity financing. Proponents of the tax change argue that
reducing the tax benefits of debt financing would allow better allocation of
capital and would normalize the U.S. tax code with the rest of the world.
Nevertheless, most U.S.
companies will see an increase in their weighted average cost of capital
(WACC). According to outside estimates of the GOP proposal,
this would raise more than $1 trillion in additional tax receipts.5 However,
this change comes at a price. A November 2015 paper by RLG Forensics in
association with the Association for Corporate Growth predicts that “revenue
neutral” in terms of the federal budget is not the same thing as “impact
neutral” in terms of equity valuations or economic impact.6 Proponents
of the change argue that investment expensing and the reduction of the overall
corporate tax rate to 20 percent will offset the increase of the cost of WACC
in many cases. While this may be true eventually, the transition period is
likely to cause lumpiness in investment spending, which could well translate
into some quarters of negative growth.

The second offset, implementing a border adjustable tax, is
estimated to raise $1.2 trillion in tax revenue over 10 years. One main motivation for this
tax appears to be that it would discourage corporate inversions. As A Better Way7 notes,
“Taken together, a 20 percent corporate rate, a switch to a territorial system,
and border adjustments will cause the
recent wave of inversions to come to a halt.” However, other
claims that the change will now favor exports over imports ignores linkages
between imports, exports, and foreign exchange values. Perhaps more
importantly, if the tax
changes did reduce our imports, it would also reduce our standard of living, as
more goods and services would be sent to foreigners while receiving fewer goods
and services from them in return.8

Indeed the fact that in any given year 20–30 percent of U.S.
imports are priced in dollars means the J-curve effects of the currency
adjustment would likely take longer and could be adverse for importers of
commodities in the short term. Additionally, the linkages in global value
chains where many goods are priced in dollars, the long-term nature of
contracts, and general price stickiness throughout the value chain mean the
transition between implementation and complete currency adjustment could
disrupt U.S. and global GDP growth.

Nevertheless, many economists make several arguments in favor of a
border adjustable tax system.9

1.It would align more closely with the VAT system in most of our
trading partners where exports are not taxed but imports are.

2.Border adjustments reduce the incentive to manipulate transfer
prices by shifting to lower tax jurisdictions based on tax policy alone.

4.Proponents argue that border adjustments are not trade policy, but
rather create a level playing field between domestic and overseas competition.

5.Border adjustments do not distort trade as exchange rates should
react immediately to offset the impact of these adjustments.

Many economists agree with most of these points. We concur largely
with points 1-3 and in the long run with point 5, although the implementation
phase could cause disruption that may have a significant near-term impact on
GDP. On point 5, the
reserve currency status of the United States blunts this negative impact. Our
research suggests that the reserve currency status of the United States and
integrated global value chains could slow the rate of currency adjustment with
adverse unintended consequences for world and U.S. growth. The
stronger U.S. dollar will raise prices of dollar priced goods for the rest of
the world which will, at some point, if not immediately, lower demand for these
goods. No immediate adjustment will take place on the 20–30 percent of imports
priced in U.S. dollars, and it will raise prices and lower demand of these
goods worldwide.

Raising $1.1 trillion in taxes means that cost must be borne by
some part of the economy either domestically or by trading partners. In the example below, the
tax law change simply shifts the burden of the tax to different types of
businesses.

Auerbach and Holtz-Eakin assume that the world price of the goods
remains the same and that the dollar appreciates to offset the border
adjustment. They also appear to assume that the good is priced in foreign
currency and no long-term contracts or integrated value chains are in place.
Economic theory suggests that the higher import tax cost in the example below
does not mean that the firm does worse after tax under the new system once the currency adjustment is
completed and the cost of imports falls due to the higher value of the U.S.
dollar. Under the new law, the firm in the example below can
deduct only 20 of its purchases rather than 30 because 10 represents the
imported amount. However, as Auerbach and Holtz- Eakin’s paper explains, the
import costs will adjust to be 8 in dollar terms, rather than 10, if the tax
rate is 20 percent. This means that the firm’s after-tax cash flow will be the
same in the two cases; 80 percent of 15 = 12 under the current system, and 80
percent of 25 = 20 – nondeductible expenses of 8 = 12 under the new system.

We worry that this assumption is a bit too neat and the real-world
adjustment will be less smooth and not immediate. As the home of the reserve
currency, U.S. importers have the significant advantage of never having to
worry about currency price fluctuations (in particular a devaluation of the
dollar) impacting the purchase cost of commodities and many other goods that
are part of the global value chain. There are other advantages such as
significant demand for U.S. Treasuries keeping U.S. borrowing costs lower than
they otherwise would be. But the chief advantage for the purpose of analyzing
the border adjustable tax is that commodities trade in U.S. dollars.

The example put forth by Auerbach and Holtz-Eakin assumes the
exchange rate absorbs the tax change and the cost evaporates in currency
fluctuations. The tax law
change would then encourage investment as its full expensing regime makes this
activity more attractive; it would also blunt the impact from
the import tax. It is implicitly assumed that this greater investment will
translate into greater economic activity and yield a higher growth rate. One
may also assume one has a can opener.10

Over the long term, it seems reasonable that the proposed tax law
change would simplify the code, which in and of itself could allocate scarce
resources to better use thereby improving GDP. However, the transition to the new system as laid out in A Better Way does raise some questions, a few of
which are outlined below.

1.The assumption that all traded goods are priced in foreign
currency is a key part of most exchange rate models that one can apply to this
situation. Examples such as the Bickerdike-Robinson-Meltzer Model assume the
supply and demand schedules shift downward by the same proportion as the
appreciation.11 It also assumes the good is priced in foreign
currency terms, which for the United States is not the case for 20–30 percent
of its imports in a given year.

2.The demand elasticity is not the same for each imported product so the currency adjustment on a good-by-good basis may not be
equal to the tax change. Therefore, some importers would be more or less
advantaged as would some exporters.

3.With no offsetting tax cut, a
rise in the value of the dollar would hurt exports. With the
reduced corporate tax, exporters would presumably have room to lower the price
of their goods in line with the amount of the appreciation of the currency.
However, this transition is likely to be “lumpy” and could reduce exporters’
revenues during the transition period and beyond.

4.Not all importers are engaging in corporate inversion or are
importing goods because of tax reasons. Global
value chains (GVCs) have become increasingly integrated. In 2011, nearly half of world trade in goods and
services took place within GVCs, up from 36 per cent in 1995.12 This
is due in part to labor cost differentials, in part to sourcing of raw materials,
and in part to expertise in certain products and services. Thus, changing the
way imports are taxed for U.S.-domiciled companies is likely to cause
disruption to globally linked supply chains many U.S. multinational companies
have in place.

5.The J-curve effect means that there is a lag between when a
currency change takes place and the physical change in imports or exports is
realized in the current account balance. Usually orders that existed before the
currency move have yet to be paid for, thus the J-shaped change in the trade
balance immediately following a substantial currency move. A stronger dollar should increase the
current account deficit over time as U.S. dollar exports become more expensive
to our trading partners. Additionally, the immediate effect
would be a reduction in the current account deficit. This would be an addition
to GDP but it would also correspond to a significantly smaller capital account
surplus and would likely negatively
impact the U.S. equity market and increase U.S. interest rates, all other
things equal.

6.The idea of wanting to stimulate exports, reduce imports, and
reduce our current account deficit ignores the other side of this accounting
identity, the capital account. As Ruddy Dornbusch wisely noted, “The flow of
investment and the changes in the value of real capital potentially dominate
the effects of current account imbalances. A good week on the stock market
produces a change in wealth that is several times the magnitude of an entire
year’s deficit in the current account. Although it is true that the current
account is important because persistent current imbalances accumulate, exactly
the same argument can be made for investment.” A persistently lower current account deficit would equal a
persistently lower capital account surplus and over time higher interest rates
and lower stock market returns. Conversely, a high current
account deficit means there is a higher capital account surplus and an
abundance of capital in the U.S. market. This is also a function of our reserve
currency status; foreign holders of U.S. dollars need to invest their holdings
in U.S. assets. Therefore,
one can argue that the benefit to the economy overall of running a current
account deficit and a capital account surplus not only outweighs the costs, but
is a corollary to reserve currency status.

7.While it is commonly known that commodities trade in U.S. dollars,
it is likely less widely known that much of the global value chain of
intermediate goods also trades in dollars. This is in part because the U.S.
consumer base is the largest in the world which reinforces the United States’
reserve currency status. If at the margin a border adjustable tax caused fewer
goods to be priced in dollars, it could have the unintended consequence of pushing
the U.S. dollar further from reserve currency status.

There are of course other aspects of the A Better Way blueprint that
could have unintended consequences. The list above is meant to stimulate
thought and improvement of the plan and its implementation.

While some theory does support the idea that it would improve U.S.
GDP, there are a lot of assumptions that cannot be counted upon. It cannot be
overstated that while a major tax overhaul of this kind could in the long run
benefit the U.S. economy, the
transition is likely to be lumpy and could even see some quarters of negative
growth as adversely impacted firms or industries suffer or go
out of business.

The comprehensive and sweeping nature of the proposed tax changes
and the fact that they will be much more effective if they are permanent means
that the GOP will want to
be strategic in the way they pass the bill.

There are two
options that would eliminate
the need for a sunset provision. The first would require at
least eight Democrat senators to sign on. This means that compromise will alter
the current proposal. It also means that passage before the end of 2017 will be
difficult. Reagan’s 1986 tax law change took three years to negotiate and this
tax bill will take time as well. The second way the GOP could make the law
permanent is the so-called reconciliation process. This is only possible if the
law does not increase the deficit in any year beyond the official 10-year
budget window. Some believe this is their current plan—to construct the bill in
such a way to be revenue neutral or positive in years 11 and beyond. This too
would require significant changes to the current law. The Tax Policy Center assumes the
current plan adds to current deficit levels by $3.3 trillion over the first
decade.

In the meantime, it is expected the U.S. dollar to be the most
immediate asset to anticipate this change in policy over the course of 2017.
Any move in the dollar will be buttressed by the interest rate differential
between the U.S. and other high- grade government debt markets. Higher interest
rates will put pressure on Trump to achieve GDP wins early as it will reduce
U.S. exports, increase imports, and have a negative effect on GDP. Therefore, as stated above, regulatory
changes are expected to be sweeping withinTrump’s first 100 days.
However, even this is not a panacea as many of these changes will be seen in
the energy space where the
value of a barrel of oil will be just as important in determining investment
levels as regulatory changes. Remember, a stronger dollar
reduces the demand and price for oil in foreign currency terms, all things
being equal.

Therefore, it is fair to say that Trump’s 4 percent growth target
faces challenges from both structural and cyclical factors. Streamlining regulation is
Trump’s best bet for a quick win on increasing GDP.
__________

We are travelers on a cosmic journey, stardust, swirling and dancing in the eddies and whirlpools of infinity. Life is eternal. We have stopped for a moment to encounter each other, to meet, to love, to share.This is a precious moment. It is a little parenthesis in eternity.